The Basel Committee on Banking Supervision has revised paragraph 75 of Basel III as regards its application to derivatives.

The Basel III rule in paragraph 75 is designed to ensure that an increase in the credit risk of a bank does not, via a reduction in the value of its liabilities, lead to an increase in its common equity.

Paragraph 75 required banks to “derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.” While this rule was originally developed in the context of debt instruments issued by banks, the principle extends also to fair valued OTC derivatives. However, the application of paragraph 75 to derivatives was not straightforward.

The Committee issued a consultative document on this issue in December 2011, and wishes to thank those who provided feedback and comments.

After consideration of responses, the Committee confirmed its intention to proceed with the baseline proposal included in the consultative document and has agreed that valuation adjustments to derivative liabilities arising from the bank’s own credit risk should be fully derecognised from the calculation of common equity at each reporting date.

While recognising that this rule might go beyond the principle in paragraph 75 for non-derivative liabilities, the Committee believes that valuation adjustments to derivative liabilities raise a wide range of prudential concerns, and therefore that conservatism should drive the policy framework in this area.

In addition, the Committee believes that it is currently not feasible to implement alternative approaches in a consistent and sufficiently robust manner.

The above prudential treatment would be implemented according to the Basel III transitional provisions for regulatory adjustments, as stated in paragraph 94 (c) and (d). That is, the deduction from Common Equity Tier 1 of all accounting valuation adjustments to derivative liabilities arising from the bank’s own credit risk will be phased in, starting with 20% in 2014 and rising by 20% per year thereafter until full deduction occurs from 1 January 2018.

The revised paragraph 75 now reads:

Cumulative gains and losses arising from own credit risk on fair valued liabilities

75. Derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk. In addition, with regard to derivative liabilities, derecognise all accounting valuation adjustments arising from the bank’s own credit risk. The offsetting between valuation adjustments arising from the bank’s own credit risk and those arising from its counterparties’ credit risk is not allowed.